John Hussman: Overbought, Overbullish Climate Leaves No Room to Get Out

Posted on Jan 16th, 2007

Excerpt from fund manager John Hussman's weekly essay on the US market:

We've got overvalued, overbought, overbullish conditions, coupled with upward pressure on yields. I'll just go ahead and give it a name: âOvoboby.â To convey some idea of the potential risks, I've assembled a very simple set of conditions that, taken together, have usually been followed by awful near-term returns, not to mention long-term disasters. Importantly, these conditions have been unfavorable even when earnings have been growing, interest rates have been reasonably low, and the prevailing trend of the market has otherwise appeared quite strong...

Hazardous Ovoboby

Overvalued: S&P 500 price/peak earnings greater than 18

Overbought: S&P 500 at a 4-year high, and at least 5% higher than its level 6 months earlier

Here is an exhaustive list of the instances where we've observed this set of conditions on a weekly closing basis...

April 30, 1965: The Dow advanced less than 2% to its May 14, 1965 peak, 10 trading days later. The Dow then skidded -10.5% lower over the next 30 trading days.

December 18, 1972 and January 5, 1973: The Dow advanced less than 2% from the first instance, and a fraction of a percent from the second instance, to its bull market peak on January 11, 1973. The Dow then toppled -12.3% over the next 50 trading days, and collapsed to half its value over the following 22 months.

August 14, 1987 and August 21, 1987: No remark is really necessary, but for the record, the Dow advanced less than 2% from the first instance, and a fraction of a percent from the second instance, to its bull market peak on August 25, 1987. The Dow then crashed -36.1% over the following 38 trading days.

April 3, 1998: The Dow advanced another 2.5% over the following 6 weeks to a preliminary high on May 13, 1998, and quickly dropped -6.3% over the following 22 trading days. The market then enjoyed a short-lived 8.1% rebound over the next 22 trading days to a fresh high on July 16, 1998, before suddenly plunging -19.1% to its August 31, 1998 low, 32 trading days later (overall, a -16.1% loss from its April 3 level).

April 23, 1999: From a longer-term perspective, the market was already floating on the suds of the late-1990's bubble. Indeed, despite the recent high in the S&P 500, its total return has underperformed Treasury bills in the years since then. Still, from a short-term perspective, this was the most benign instance on the list. The Dow advanced less than 3% to a peak on May 10, 1999, followed by a selloff of -4.9% over the next 13 trading days. The lack of a deep correction, however, left subsequent gains open to repeated selloffs, erasing them even before the bear market began in earnest.

July 2, 1999 and July 16, 1999: The Dow advanced less than 2% from the first instance and about 1% from the second instance, to a peak a few weeks later on August 25, 1999. The Dow then fell -11.5% over the next 36 trading days.

December 23, 1999 and December 31, 1999: The Dow advanced less than 3% from the first instance and less that 2% from the second instance to the final peak of the market bubble a few weeks later, on January 14, 2000. The Dow then plunged -16.4% over the next 35 trading days.

March 24, 2000: The actual bull market high already behind it, the Dow had enjoyed a bounce off of an early-March low. It advanced less than 2% further, to a short-term peak 12 trading days later. The Dow then dropped -8.8% over the following 32 trading days. Over the following 30 months, the stock market would lose half its value.

November 17, 2006, December 8, 2006 and January 12, 2007: We'll find out shortly...

Normally, market internals deteriorate in a way that provides more time to establish a defensive position -- market breadth lags, divergences develop across various industries and security types, price/volume action shows signs of distribution and so forth. The overvalued, overbought, overbullish syndrome may present none of those warnings, particularly when there is even modest upward movement in Treasury yields.